DP16958 Asset Pricing with and without Garbage: The Overlooked Triple-Hypothesis Problem

Author(s): Stefanos Delikouras, George Korniotis
Publication Date: January 2022
Date Revised: May 2022
Keyword(s): Consumption Growth, Cross-section of expected returns, Epstein-Zin Preferences, GMM, Risk-free rate
JEL(s): D51, D91, E21, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16958

Testing consumption-based asset pricing models is a triple hypothesis, which requires selecting the consumption data and examining the assumptions for investor preferences and consumption dynamics. We formalize the triple-hypothesis problem within a GMM framework that relaxes the CRRA assumption, jointly estimates consumption dynamics with Euler equations, and includes the risk-free rate variance as a target moment. We find that consumption measures proposed as alternatives to the BEA consumption (e.g., garbage) do not address the shortcomings of the canonical CRRA model with i.i.d. consumption growth. Instead, a model with BEA consumption, Epstein-Zin preferences, and non-i.i.d. consumption dynamics performs equally well.